April 17, 2008

The Reserve Bank of India is considering launching a Sovereign Wealth Fund which will effectively allow it to invest its excess reserves in higher yielding assets that are off-limits to it right now. This is on the back of the $5 bn set aside in the 2007 budget for the India Infrastructure Finance Corporation. Critics have quickly pointed to the East Asian Financial Crisis of 1997 as to why this is a bad idea. Here is a quick historical perspective.

For much of human history, the trade of Europe with South-Eastern Asia, particularly India and the countries of the Malay archipelago, has been the most lucrative branch of world commerce. The monopoly and control of this trade route was thus much prized by nations, from the early Roman empire, to the Byzantine empire, and later in the 15th century the Italian cities of Venice and Genoa. Then the Portuguese found the sea route around Africa and spent much of the 16th century swiftly proceeding to become the dominant power in this trade, cutting not just the Venetians, but also the Sultans of Alexandria and Constantinople, effectively cutting the supply chain a few layers. It was a remarkable achievement for a tiny country which had to contend with the Italians and the Sultans, and yet built fortifications along the Indian Ocean rim to protect its trade.

In 1580, Spain annexed Portugal in Europe, and the Spaniards, rather stupidly in hindsight, decided that they were not interested in preserving what the Portuguese had worked so hard and energetically to establish – a monopoly of the most lucrative trade route in human history. The reason is interesting.
While Bartholomeo Diaz and Vasco Da Gama were finding the Eastward trade route to India, Spain dispatched one Christopher Columbus on a misguided Westward journey to India. Now the “India” or “Indies” that Columbus found quickly became the exclusive domain of Spain, where they found that they could simply dig up precious metals like gold and silver. They decided that it was good to keep your gold and silver in the country than to use it. And trade with India virtually meant that gold would leave your country and end up in India.

Without the lure of trade, Spain had little incentive (despite stated intent) to prevent the budding merchant powers like Holland, England and France from entering this trade. From the time Sir Thomas Roe got trading rights from Mughal Emperor Jehangir around 1605, the British East India company spent the next hundred years becoming the dominant power in this trade route.

Note that at this time, India was still just a prized trading partner. Territorial expansion, much less an empire were a distant dream, minus the resources that the Industrial Revolution would bring and the presence in India of powerful rulers like Aurangazeb and Shivaji.

So even while the shareholders of the East India Company were rolling in cash, a powerful backlash was building up against the company in England, on the basis of the same false mercantile theory that had held back Spain a century ago. The company was accused of impoverishing England by despatching bullion to India.

Fortunately for England, she had a strong merchant class who from real experience of distant commerce correctly understood that gold must be allowed to find its own natural price level, or must simply fall in value.

The rest as we know is history. England went on to build one of the largest and definitely most sprawling empire in history, became the most powerful and richest nation in the world. Other European powers achieved similar though modest in comparison successes. Spain went on to lose most of her colonies in the New World and the old, even before the English empire had reached its peak.

And what of the nation that for many centuries bled Europe of its bullion – India? 18 centuries is a long story, but it too was largely hoarded (in different ways and different places). With exceptions like the Cholas and the Marathas, few Indian rulers invested in a navy. Trade with Europe was largely dominated by foreigners, with Indians at best accounting for the first leg of the journey to the start of the land route through the Levant. Moreover the hoarded wealth was easy picking for invaders whether from the Afghan passes or the sea trade routes from Europe.

It must be noted in conclusion that the British Indian Empire was originally built as a commercial venture by a trading entity which would have been a non-starter if the British were paranoid of bullion (or excess reserves) leaving their shores.

[...] to invest its stash of excess reserves. Kiran launches into an interesting history narrative to explain why this is a bad idea. Whether you agree with the conclusion or not, you will love the History lesson! While Bartholomeo [...]

‘Fortunately for England, she had a strong merchant class who from real experience of distant commerce correctly understood that gold must be allowed to find its own natural price level, or must simply fall in value.’

Is there any evidence you could cite here? To me it looks like a simpler theory explains it. There was a sufficiently large merchant class that found this trade to be immensely profitable. And they used this clout to make sure safeguard their interests.

England’s rise was primarily due to the Industrial Revolution. It’s not clear how the presence of a large mercantile class automatically led to the Industrial Revolution. A combination of factors, including difficulty in extracting coal, general advancement of science, are more likely. Early steam engines were meant to alleviate this problem. Agreed that the merchants soon found in technology a powerful tool in trade, and eventually, in conquest.

industrial revolution came AFTER the east india company had been established. so basically the first thing that happened in england was that the merchant class got powerful. and for the merchant class to be successful, you need to have a good law and order situation and good governance and enforcement of contracts etc. and so the merchants supported the “glorious revolution” which gave parliament absolute rights. and it was after this that the industrial revolution took place.

Sovereign wealth funds are created when there is excess money that cannot be productively invested in one’s own economy.It is suitable for tiny countries like Qatar and others like China which are running out of ideas as to what to do with $1.6 trillion in reserves.
We in India have ample investment opportunities in our own country infrastructure,agriculture(where our yield per acre is 1/10 that of israel which is a desert!) etc etc.
SWF aren’t something one should look at in our present state of development.

@photonman – The post does not imply that there was a direct link between the existence of the strong mercantile class and the industrial revolution. There might have been a link, but that is a different story. The merchants did ensure however that foreign trade continued. This led to England acquiring the most profitable colony in the world then. And resources from India did help fund the Industrial revolution – maybe significantly or maybe not.

Interesting. I seem to have misunderstood your post entirely. I thought you were arguing for use of excess reserves to promote trade.

The RBI wants to invest in SWFs to earn “higher returns”. Higher, presumably, than what they can earn in India. I’d love to hear which countries would offer such returns, and what the risk-adjusted return in this case would really be.

Here is a great article arguing why such SWFs are a bad idea for the investing country.

@Lekhni
Here is a description of the RBI plan:
“under consideration is a sovereign fund structure in which a separate entity or company will purchase foreign currencies from the central bank. In return, the Reserve Bank of India will receive shares of the fund, which will be able to invest in higher yielding assets that are off-limits to the central bank under its current mandate.” Source: BW
“Re-invest excess reserves” does not equal “lock up trade gains in illiquid assets”, unless you argue that “re-invest” equals “lock-up” and “higher yielding” equals “illiquid”. Thats the trade-off between liquidity and yield I guess.

Yes, I do believe that higher yielding means both risky (since returns are, after all, a trade off for risk) and illiquid.

I would argue that the only instrument which has been considered as neither risky nor illiquid is US Treasuries. But there is only so many Treasuries that can be bought. Already, foreign central banks account for about 40% of Treasury demand..and I am sure now they desperately need to diversify.

Where do they go now? If they continue to invest in US assets, they will have to get into the business of propping up distressed companies by infusing capital, buying CMOs and buying property. Yes, all this is already being done by other countries.. We have already seen how risky these investments turned out to be (all those Norwegian investments in mortgage backed securities? Wiped out). All bad investments even in the US context, despite very liquid capital markets and a highly developed economy. I don’t even need to talk about how investing in other countries is even more risky and illiquid.

P.S. Why do I keep getting this “WP Hashcash Check Failed” message when I comment on your blog :(

Hi,
The Indian rupee has appreciated roughly 8.67% approx against US$ in last 6 months, the Indian reserves has increased in US $ terms.
On the other hand crude prices is around $117 a barrel and may touch US $ 120 per barrel very soon. This situation can only be bailed out if you have an alternative source of energy or 123 Agreement signed.
The reserves that RBI is holding apparently seem to be high but it is a tight rope walking for the government. The inflationary trends (7.4%) are continuing, import of crude is balancing out the rupee appreciation of rupee. Indian Inflation is being imported from outside along with the crude.
The economy is not a state of honky dory, RBI should hold on to its reserves. Sovereign Wealth Fund will not be advisable at this moment.

Regarding the economic history you have said is good, the maritime nations of Europe, Britain, Portugal and Spain were very adventurous and particularly had traders bent of mind.
They were restricted up to Aden where they sold their products to the Moorish (Arab) traders, the Arab used to come to Indian subcontinent and Far Eastern countries.
They had a an advantage, particularly Britain had a very good educational setup, even Sir Thomas Row who came in court of Jahangir was an Oxford graduate. Cambridge and Oxford are considered to be one of the oldest universities of the world still maintaining world-class standards. British diplomats are of world-class standards, which in turn helped the business and trading community.
They had democracy, Labor party, Conservative party, choosing governments in spite of Monarchy and a very feudalistic society. The Houses of Commons and Houses of Lords were there.
The Joint stock companies started in England, the limited liability concepts; the double entry system of book keeping was there 200 years before. The Scott man James Watt and Englishman Matthew Boulton started Watt & Boulton a partnership co, the first Engineering solution selling firm in the world. The technological evangelisms along with business acumen are unique combinations that the British business class had.

After WW-II it was no more Britain, it became Anglo American power with commercial and business interest, the communist block broke down into pieces 1991.
The golden rule of” divide and rule” is unique in nature with Brits (Anglo Americans).
They used it in India, Pakistan, North Korea, South Korea, Mainland China, Taiwan, Shia, Sunnis in Iraq and still practicing accurately which is giving them immense benefit in business terms.
As of now it is the Anglo American political hegemony and defense technological supremacy that is helping them to have a global business edge. You cannot be successful in global business, if you don’t have political supremacy and smart diplomatic ties for better business interest.
Now the world is standing in the cross road of capitalism, the epicenter of capitalism is shifting from North America to Asia. The Economic Block like BRIC cannot be ignored any more, especially RIC are on the same global axis.

What you say still doesn’t answer my first question about the blog’s claim that the English traders ‘correctly understood that gold must be allowed to find its own natural price level’.

A simpler and more reasonable explanation is that the traders were powerful enough to influence the political class. I am not aware if the ‘rule of law’ in honoring contracts was any stronger in pre-industrial England as compared to its peer countries like contemporary France, the Dutch republic or the Russian empire.

Gold has no value, unless someone else agree to accept it in exchange one more exchange is required to realise value. Where as food etc has real usable value that can be immediately consumed.

Gold cannot be used as a store of value, because what value can be realised depends on what others are ready to exchange it for, for eg. during a famine the guy holding gold will starve to death, while a guy holding food grains can eat it and exchange it for other goods and services. This means Amartya Sen theory that Bengal famine happened due to lack of money supply is pure bunkum, it happened due to lack of food.

I was expecting this discussion to be about the RBI’s plans to set up a wealth fund. In that sense, Lekhni’s link to the article on foreignpolicy.com article presents an excellent case on why we shouldn’t be going for one.

Although investing does increases the chances of return but at the same time it increases the risk too. And the question that I want to ask is that what are exactly the high yielding assets? If we look at USA today, its economy is going into recession ( has already hit it as far as I know ). Sub prime crisis is a fine example of things going bad. Other nations like Africa and smaller ones are in no position to give us a benefiting deal in these terms at least. That leaves China and Europe. Since China is ,as someone said, sitting on a heap of excess reserve in trillions, it is competing with us to invest that. So, effectively, its just the European Union that’s left. Now I do not have much idea about how secure the excesses would be there.

And as someone said, would it not be better to take care of domestic reforms first, stabilize and strengthen things here a little and then take a step forward. You said that England benefited because it did not hoard but invested. The question is that was at that time England wanting that money to be invested in its homeland? Was the bullion purely excessive or was the investment done at the cost of curbing the internal development? I think we need to look at that too because as someone mentioned England was fairly developed at that time. So, I am thinking that at this point, home improvement comes first before looking out so vigorously.